How rate hikes impact your financial plan

Last month, the Reserve Bank of India (RBI) increased the repo rate by 50 basis points (bps). Rate hikes have negative and positive impact. The negative impact is on the liabilities, which will become costlier than what they are currently. The positive impact is that now people will be able to earn higher returns on fixed deposits. Looking at the past few months, where the credit growth has declined, banks may not pass on the entire burden of this increase in rate to the new customers. But some of the increase will definitely be passed on. The existing customers are always the one who are affected more than the new customers in case of such rate hikes. In the event of increase in loan rates, the banks may either choose to increase your equated monthly instalments (EMIs) or they may increase the tenure of the loan. Generally, the banks choose to increase the tenure of the loan for two main reasons. Firstly, the banks already have post-dated cheques or ECS instructions for the EMI amount and any change in the EMI will mean changing all the previous instructions. Thus, administratively, it suits the banks better to keep the EMI same and increase the tenure. Secondly, any increase in tenure does not impact the monthly household budget; hence the chances of default do not rise. However, there is a limit upto which banks can keep increasing the tenure. Obviously, the increase in tenure can not be such that the loan repayments exceed even your retirement age. Thus, beyond a point the bank is forced to increase the EMI rather than tenure. Existing loan customers are the ones who suffer the most, due to these interest rate hikes. The floating interest rates are generally linked to base rate or the prime lending rate. After the increase in interest rates, the banks generally increase their base rates and prime-lending rate. This directly impacts the existing customers as their loans become costly. But for new customers the banks may reduce the spread over the base rate and thus charge them less. For instance, suppose the bank's current base rate is 9.5% and you have got an interest rate of base rate plus 1%. Your effective interest rate is 10.50% (9.50% + 1%). Now, if the bank increases the base rate by 0.50% to 10% your effective rate becomes 11% (10% + 1%). The bank may start charging new consumers at base rate plus 0.75%, thus charging them only 10.75% (10% + 0.75%). This kind of discriminatory changes have happened in the last round of increases and will definitely happen this time around also. People who took loan 2-3 years ago are the worse victims. The home loan rates were then 8 to 9% per annum. These rates have gone up to 12 to 14% per annum. These customers should immediately shift to the new base rate regime, which is more transparent. First find out the existing home loan rates. If you are paying more interest rate than what other lenders are offering, you should talk to your lender first and see if he is ready to shift you to a lower interest rate on the base rate system on payment of some fees. If the lender doesn't give you that option or does not give you the same rate that he is charging to new consumers, you should shift your loan to another lender. Don't worry about the prepayment charges. There are plenty of banks who will takeover the loan and give you a loan for the prepayment charge and have nil processing charges. You do not need to do complicated calculations to find out if the shift makes sense. If the tenure of the new loan is lower than the old one (with EMI remaining the same) and there is no cash outflow from your pocket, you are getting a better deal. It is sheer inertia that is probably keeping you from saving money every month. With the interest rates nearing its peak, it is a good time to lock in your fixed income investments at the higher rates. Currently, fixed deposits are offering return in a range of 8 to 10% per annum for a period in excess of 1 year. Fixed maturity plans will really offer the best post-tax returns because of their structuring. So all in all, we live in "interest"ing times, but need to act to protect our own interests.